For a bank with such a white-shoe history and reputation, Morgan Stanley has demonstrated a masochistic tendency over the past few years to trip up almost every time it looked like it was getting back on its feet.

Gorman: Morgan Stanley proved its trading business wasn’t broken

In 2005 the bank nearly tore itself apart from the top down. It nearly blew itself up from the inside in 2007 after its ill-fated push into asset-backed securities went badly wrong.

But, having wriggled out of the same fate as Lehman Brothers or Merrill Lynch in 2008, and shrugged off rumours over its survival last year, Morgan Stanley had seemed to be back on track after a storming start to the year.

But just as everything was looking rosy, it returned to form in the second quarter, when the threat of a three-notch downgrade by Moody’s hung over the firm like a bad smell and sent clients running for cover. With that threat lifted in June – the bank was downgraded by just two notches – Morgan Stanley came bouncing back.

Over the past three months, revenues in the investment bank jumped by around a quarter (once you strip out the accounting treatment of the bank’s own debt), fixed-income trading came roaring back, and pre-tax profits more than doubled in the bank’s institutional securities division. As chief executive James Gorman noted, Morgan Stanley had proved that its trading business wasn’t broken.

But the reaction to this rebound at Morgan Stanley seems a little overplayed. In a world in which scale and capital efficiency have become essential determinants, Morgan Stanley’s investment bank still has neither. Despite the rebound, it is the smallest, least profitable and arguably the weakest of the big five US investment banks, and it is less clear whether it will be able to return to sustainable profitability than its third-quarter results might have you believe.

Wrong side of the street

Over the first nine months of the year, Morgan Stanley’s institutional securities division performed worse than the Wall Street average on almost every measure when compared with the same period last year, according to my analysis (see chart). In several areas (notably fixed-income trading, return on equity and investment banking) it performed worst of all in relative terms.

Overall revenues of $11.7bn from markets (that is, fixed income, equities and investment banking) so far this year are down 11% on last year compared with an average uptick of 2%. In fixed income, where it is scarcely half the size of its bigger peers, Morgan Stanley was the only firm to post a drop in revenues this year. In equities, BAML was the only bank to deliver a worse relative performance.

Perhaps more worrying is that revenues in investment banking, which had proved remarkably resilient at Morgan Stanley throughout the crisis, dropped by 19% this year – worse than any of its peers and nearly double the average decline. One rival and admirer of Morgan Stanley said this was “worth keeping an eye on” to see if it is a blip in a lumpy market or the start of something more structural.

Of course, the threat of the downgrade explains a large chunk of the fall in fixed income, but it doesn’t explain the drops in equities or investment banking. And the dire performance of some of its rivals in 2011 flatters their performance relative to Morgan Stanley this year. But neither factor can explain away Morgan Stanley’s more fundamental strategic challenges.

First, costs. Gorman has been a vocal critic of pay on Wall Street, but despite a 9% fall in compensation in the investment bank this year overall costs have fallen by just 5%. Even after the “rebound”, the cost/income ratio in institutional securities in the third quarter was 91% and its pre-tax return on equity over the first nine months was just under 10%, little more than half where it needs to be and the worst on Wall Street.

Second, and more important, is the balance between scale and capital. Morgan Stanley has made encouraging progress in restructuring its trading business and reducing risk-weighted assets in its investment bank, although somewhat unhelpfully it doesn’t disclose them and it is unclear whether it can shift them as fast as it needs to.

This leaves it with a sub-scale and volatile fixed-income trading business, coupled with an outsized balance sheet of around $635bn (as of the second quarter). For context, this is roughly two thirds the size of Goldman Sachs’ group balance sheet, but the division generates less than half the revenues and little more than a quarter of the profits of its old rival.

Getting the institutional securities division right is an essential part of Gorman’s strategy at Morgan Stanley, even as he shifts the balance of the firm towards retail and wealth management. At the moment, none of the parts is really firing on all cylinders.

Morgan Stanley will need to string together a few more quarters without tripping up before it becomes clear whether its first-class equities and investment banking business can ride to the rescue, whether the bank can rework its fixed-income business sufficiently, and whether it can return to sustainable profitability.

Alternatively, something more drastic – such as a radical restructuring of the investment bank or sale to a bigger and possibly Japanese partner – may be required for Morgan Stanley to retain its seat at the top table on Wall Street.

--William Wright is a columnist on investment banking. Contact him on william@william-wright.com and follow him on Twitter at www.twitter.com/williamw1

--This article was first published in Financial News's print edition on Monday, October 29, 2012